CFTC Staff Letter 13-88: No-Action Relief for Production Payment Vehicles

Gary Barnett
Director
U.S. COMMODITY FUTURES TRADING COMMISSION
Three Lafayette Centre
1155 21st Street, NW, Washington, DC 20581
Telephone: (202) 418-5977
Facsimile: (202) 418-5407 gbarnett@cftc.gov
Division of Swap Dealer and Intermediary Oversight CFTC Letter No. 13-88 No-Action March 29, 2013 Division of Swap Dealer and Intermediary Oversight Re: “X” request for exemption of Production Payment Vehicles from commodity pool regulation Dear:
This letter is in response to your letter dated March 29, 2013, to the Division of Swap Dealer and Intermediary Oversight (the “Division”) of the Commodity Futures Trading Commission (the “Commission”), as well as additional email correspondence with Division staff. You request on behalf of “X” (collectively, “X”) confirmation that the Division would not recommend enforcement action against the commodity pool operator of “production payment vehicles” for failure to register as such. Based upon the representations in your letter, we understand the relevant facts to be as follows. Production payment vehicles are oil and gas financing structures used by U.S. oil and natural gas producers which execute swaps to hedge market risks of a physical production payment asset that they own. Because of the inclusion of swaps as a commodity interest within the definition of a commodity pool under Section 1a(10) of the Commodity Exchange Act, such vehicles may be classified as commodity pools. You describe production payment vehicles as special purpose entities that own passive, non￾operating, overriding royalty interests in oil and natural gas well production that entitle their owner to receive delivery of a certain volume or value of liquid or gaseous hydrocarbons, typically each month, for a specified period of time, determined without regard to production costs. Stated another way, the oil or natural gas company (the “Seller”) conveys the right to receive production from the subject wells that are identified in the conveyance up to an agreed upon volume. You state that the production payment vehicle issues debt or debt-like instruments, which are fixed income securities. You also state that the vehicle receives and immediately sells the hydrocarbons received by it each month under the production payment at a then-market price. You state that the transaction is structured so that the scheduled production volumes delivered will generate cash proceeds, based on the sale of production on or around each of the payment dates at prices derived from the forward curve in existence on the execution date of the assignment or conveyance, that provide an investment grade likelihood of being sufficient to repay the issued securities. Additionally, you state that you reach the investment grade likelihood of repayment sufficiency through applying a “period production coverage” to the production stream and a “tail coverage” such that

2 there is a high degree of certainty that the cash flow will exceed the payments required under the issued securities. In the event that there is a shortfall in the scheduled production delivery, you state that a cash calculated make-up amount accrues, which is based on the market price for that delivery period, and to the extent that there is excess production in subsequent months, the Seller must provide make-up volumes sufficient in volume at then current market prices for that future delivery period to satisfy that make-up amount. Additionally, you also state that concurrent with the acquisition of the production payment, the production payment vehicle enters into swaps to hedge its commodity market risk related to the sale at market price of the physical hydrocarbon production and the interest rate exposure enabling it to service the fixed income securities. You state that the production payment vehicle does not trade in and out of swaps to generate profits or mitigate losses. You also state that the Commission has previously recognized that a production payment vehicle’s commodity swaps would qualify as bona fide hedges for purposes of position limits. 1

Based on the representations in your correspondence, the Division will not recommend that the Commission take enforcement action against the operator of a production payment vehicle for failure to register as such, provided that the production payment vehicle’s use of swaps satisfies the following conditions:

1. The swap(s) will have the effect of reducing risk relative to the risk of the unhedged
   position;
2. The swap(s) position cannot be established, held, altered or terminated for the
   purpose of speculation or trading;
3. The swap(s) will only hedge risks inherent in the physical assets of, or the fixed
   income securities issued by, the production payment vehicle and not risks arising from the arrangement by which the assets are held or financed;
4. The hedged physical asset and its cash flows , without benefit of the swaps or other
   hedging transactions, would provide at least an investment grade likelihood 2 of paying and retiring the production payment vehicle’s securities in accordance with their terms;
5. The swap(s) will not introduce any new risks to the production payment vehicle other
   than counterparty risk; and
6. The terms and conditions of the swap(s) are consistent with those generally available
   in the non-structured, traditional swaps market; and

1
Position Limits for Futures and Swaps, 76 Fed. Reg. 71626 (Nov. 18 2011), vacated by U.S. District Court for the District of Columbia, September 28, 2012. 2 This may be derived through internal rating processes which are executed consistent with reasonable risk management policies and procedures.

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7. The servicer or sponsor of the production payment vehicle will have employed
reasonable risk management policies and procedures to reasonably ensure compliance with the terms of this letter including periodic testing to confirm ongoing compliance with respect to any amendments to the swap(s) or the structure. Based upon the facts provided to the Division in your correspondence, you have represented that the swaps engaged in by the production payment vehicles satisfy the aforementioned conditions. This letter, and the positions taken herein, represent the view of this Division only, and do not necessarily represent the position or view of the Commission or of any other office or division of the Commission. The relief issued by this letter does not excuse the affected persons from compliance with any other applicable requirements contained in the Act or in the Commission’s regulations issued thereunder. This letter does not create or confer any rights for or obligations on any person or persons subject to compliance with the Commodity Exchange Act that bind the Commission or any of its other offices or divisions. Further, this letter, and the relief contained herein, is based upon the representations made to the Division. Any different, changed or omitted material facts or circumstances might render this letter void. Should you have any questions, please do not hesitate to contact the undersigned at 202-418- 5977 or Amanda Olear, Special Counsel, at 202-418-5283. Very truly yours, Gary Barnett Director Division of Swap Dealer and Intermediary Oversight cc: Regina Thoele, Compliance National Futures Association, Chicago